economics 121 principles of macroeconomics the demand side ... · aggregate demand (ad) the effect...

The BusinessCycle

Firms, theStock Market,and CorporateGovernance

The FinancialSystem

AggregateDemand (AD)

Economics 121Principles of Macroeconomics

The Demand Side: Consumption, Saving, and Investment

Dennis C. Plott

University of Illinois at ChicagoDepartment of Economicswww.dennisplott.com

Summer 2015

Dennis C. Plott (UIC) The Demand Side: Consumption, Saving, and Investment ECON 121 – Summer 2015 1 / 101

www.dennisplott.com

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An Idealized Business Cycle

Ï While real GDP per capita has risen about eight-fold since the start of the 20th century, it has not risenconsistently every year.

Ï Since at least the early 19th century, the American economy has experienced alternating periods of expandingand contracting economic activity.

Ï The figure shows a typical idealized path for real GDP – rising, falling, then rising again.

Ï The phases of rising are known as expansion; the periods of falling are recessions.

Ï We refer to the points at which the economy changes from one phase to the other as peaks or troughs,respectively.


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An Actual Business Cycle

Ï This figure shows the movements in real GDP in the U.S. from 2006 to 2013.Ï The period of recession starting in late 2007 and ending in mid 2009 was the

longest and most severe since the Great Depression of the 1930s, promptingsome to refer to it as the Great Recession.

Ï Real GDP growth after this recession has been slower than is typical at the startof a business cycle expansion.


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How Do We Know When the Economy Is in a Recession?

Ï The federal government does not define when a recession starts or ends.Ï The typical media definition of a recession is “two consecutive quarters of

declining real GDP.”Ï Most economists defer to the judgment of the National Bureau of Economic

Research (NBER):Ï “A recession is a significant decline in activity spread across the economy, lasting

more than a few months, visible in industrial production, employment, realincome, and wholesale-retail trade.”


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National Bureau of Economic Research (NBER)

Ï The NBER is a private nonprofit research organization founded in 1920 and dedicatedto promoting a greater understanding of how the economy works. (www.nber.org)

Ï The Business Cycle Dating Committee of the National Bureau of Economic Research(NBER) determines when a recession begins and ends.

Ï Government agencies collect most of the data the NBER uses to determine thesedates. There is a lag before the first estimates of these data are released, and the firstestimates are often revised several times as more complete information becomesavailable. As a result, the NBER committee takes time to analyze the revised databefore announcing when a recession has begun or ended.

Ï For example, the committee waited 15 months to announce that the recession thatbegan in 2007 ended in June 2009. Government and private decision makers aretypically unwilling to wait a year or more before taking action if they believe that arecession has begun. Knowledge of key macroeconomic data is important todetermine business cycle dates as well as to make critical economic decisions.measure the unemployment rate?


www.nber.org

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Can a Recession Be a Good Time to Expand?

Ï Historically, recessions have generally been followed by periods of strongeconomic growth.

Ï Some firms take advantage of the low real interest rates that typically accompanya recession to make investments by expanding productive capacity, effectivelybetting that the growth will justify their investments.

Ï For example, VF Corporation (the largest apparel maker in the world, includingbrands such as North Face, Timberland, and Wrangler) decided to open 89 newstores in 2008 and 70 in 2009.

Ï By 2013, the company’s sales and profits continued to increase, making theirdecision look very smart.


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Effect of Business Cycles on Firms

Ï When a recession hits, workers reduce spending due to expectations abouttheir current and future incomes decreasing.

Ï But this reduction in spending doesn’t affect all goods equally. Consumersmostly continue to buy nondurables like food and clothing. But purchases ofdurable goods, ones that (by definition) are expected to last three or moreyears, are more strongly affected.

Ï This includes goods like furniture, appliances, and automobiles – goods thatconsumers can continue to use for a little longer when their purchasing powerdecreases.

Ï Hence firms selling durable goods are more likely to be hit hard by a recession.


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The Effect of the Business Cycle on Whirlpool

Ï Whirlpool makes household appliances – durable goods. So we expect theirsales to be strongly affected by recessions.

Ï The charts show that the entire household appliance industry was particularlyhard-hit by the recession of 2007–2009.


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The Effect of the Business Cycle on Inflation

Ï The inflation rate measures the change in the price level from one year to thenext.

Ï During expansions, demand for products is high relative to supply, resulting inprices increasing – high inflation.

Ï During recessions, demand for products is low relative to supply, resulting inprices increasing more slowly or even decreasing – low inflation or deflation.

Ï The graph on the next slide shows the movements in the (CPI) inflation rateover the last two decades.


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The Effect of Recessions on the Inflation Rate

Ï Notice that inflation tends to rise toward the end of an expansion and fall overthe course of each recession.


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The Effect of the Business Cycle on Unemployment

Ï As firms see their sales start to fall in a recession, they generally reduceproduction and lay off workers.

Ï Notice that unemployment often continues to rise after the end of eachrecession.


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Fluctuations in Real GDP

Ï Annual fluctuations in real GDP were typically greater before 1950 than after1950. Economists refer to this as the “Great Moderation”.


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Is the “Great Moderation” Over?

Ï The length and severity of the recession of 2007–2009 has made someeconomists and policymakers wonder if we would return to the post-1950pattern of long expansions and short, mild recessions.

Ï To judge whether this Great Moderation is over, it is useful to consider why hasoccurred at all and consider what if anything has fundamentally changed.


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Explaining the Great Moderation

Ï Several factors help to explain the Great Moderation:Ï The increasing importance of services

Ï Manufacturing (especially of durable goods) is more strongly affected by recessions.The economy is based more on services now, decreasing the effect of the businesscycle on GDP.

Ï The establishment of unemployment insuranceÏ Before the 1930s, unemployment insurance and other government transfer programs

like Social Security did not exist. These programs increase the ability of consumers topurchase goods and services during recessions.

Ï Active federal government stabilization policiesÏ Many, though not all, economists believe that active government policies to lengthen

expansions and minimize the effects of recessions have had the desired effect. Thedebate over the role of government in this way became particularly intense duringthe recession of 2007–2009.

Ï Increased stability of the financial systemÏ The severity of the Great Depression of the 1930s was in part caused by instability in

the financial system; similar instability exacerbated the recession of 2007-2009.Returning to macroeconomic stability will require a stable financial system.


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Common Misconceptions to Avoid

Ï Economists often have different terms to describe a variable and changes inthat variable:

Ï Real GDP vs. economic growth rateÏ Price level vs. inflation

Ï A “trough” is the end of a recession – the lowest point GDP obtains beforebeginning to rise again. Don’t confuse “trough” and “recession”.

Ï Recessions do not affect all firms equally.


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Types of Firms

The Structure ofCorporations

How Firms RaiseFunds

Using FinancialStatements to Analyzea Corporation

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Why Firm Structure, Finance, and Governance?

Ï In this section we will examine how firms are run:Ï How they are organized,Ï How they obtain financing,Ï How they convey information to the public, andÏ Whether they act in the best interest of their owners.

Ï Each of these items affect how firms behave, and what their overall impact onthe economy will be.


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The Types of Firms

Ï Firms are legally categorized in the U.S. as one of the following:

DefinitionSole proprietorship: A firm owned by a single individual and not organized as acorporation.Partnership: A firm owned jointly by two or more persons and not organized as acorporation.Corporation: A legal form of business that provides owners with protection fromlosing more than their investment should the business fail.


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Who Is Liable? Limited and Unlimited Liability

Ï In a sole proprietorship and partnerships, no legal distinction is made betweenthe assets of the firm and the assets of its owner(s).

DefinitionAsset: Anything of value owned by a person or a firm.

Ï This is not the case for corporations. The owners of corporations have limitedliability, a legal provision shielding owners of the corporation from losing morethan they have invested in the firm.

Ï Limited liability makes raising funds easier for a firm; it also makes investing infirms easier for individuals.


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Differences among Business Organizations

Ï There is not a unique best business structure.

Ï Corporations benefit from limited liability but are expensive to organize.

Ï Also, their profits may be taxed twice: once as corporate profits and again whenthe profits are disbursed to investors.


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Proportions of Business Organizations

Ï Nearly three-fourths of firms are sole proprietorships, and just one in six is acorporation.

Ï But since larger firms tend to be corporations, most economic activity takesplace through them.


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The Importance of Small Business

Ï Most economists argue that small firms are vital to the health of the economy.Ï In a typical year, new small firms create 3.3 million jobs; 40% of all new jobs

created.Ï Similarly, while large firms may be good at improving existing products, small

firms are often better at creating new and innovative products and services.Ï Also, small firms are less likely to lay off workers during a recession (red bars on

the graph).


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Corporate Structure and Corporate Governance

Ï In a sole proprietorship and partnerships, the owners of the firm are typicallyinvolved in day-to-day decisions at the firm.

Ï This is not the case for larger corporations; they usually have separation ofownership from control.

DefinitionSeparation of ownership from control: a situation in a corporation in which the topmanagement, rather than the shareholders, controls day-to-day operations.

Ï Owners designate a board of directors, who appoint a chief executive officer(CEO) to oversee day-to-day operations, perhaps along with other members oftop management.


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Non Sequitur : Are Corporations People? Yes!?

DefinitionCorporate personhood: A legal doctrine that gives corporations the rights conveyedto “persons” by the U.S. Constitution and laws of Congress.

Ï The most important of these rights are those in the 1st (free speech), 4th(search & seizure), 5th (due process) and 14th (equal protection) amendmentsto the Constitution.

Ï Mother Jones “10 Supreme Court Rulings – Before Hobby Lobby – That TurnedCorporations Into People” by Alex Park 10 July 2014

Ï Murray Hill for Congress


http://www.motherjones.com/politics/2014/07/how-supreme-court-turned-corporations-people-200-year-saga

http://www.motherjones.com/politics/2014/07/how-supreme-court-turned-corporations-people-200-year-saga

https://www.youtube.com/watch?v=HHRKkXtxDRA

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Raising Funds as a Small Business Owner

Ï Small business owners have three principal methods of raising funds:Ï Retained earnings

Ï Profits reinvested in the firm, instead of paid to firm owners.Ï Recruit additional owners

Ï Such an arrangement would increase the firm’s financial capital.Ï Borrow

Ï From financial institutions, or from friends or family.


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Raising Funds as Your Firm Grows: Indirect Finance

Ï As firms get larger, the need to obtain external funds tends to grow.

Ï The economy’s financial system facilitates the transfer of funds from savers toborrowers.

Ï Firms can borrow money from banks. As such, the banks are acting as financialintermediaries, permitting indirect finance of the firm by their savers.

DefinitionIndirect finance: A flow of funds from savers to borrowers through financialintermediaries such as banks. Intermediaries raise funds from savers to lend tofirms (and other borrowers).


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Raising Funds as Your Firm Grows: Direct Finance

Ï Alternatively, firms can appeal directly to potential investors for funds. This isdirect finance: the flow of funds from savers to firms through financial markets,such as the New York Stock Exchange.

Ï Direct finance generally takes the form of one of two financial securities:

DefinitionBonds: Financial securities that represents a promise to repay a fixed amount offunds.Stocks: Financial securities that represents partial ownership of a firm.

Ï There are different types of interest investments:Ï Corporate bonds are considered more risky than federal government bonds, so

pay a higher interest rate.Ï Long term investments are more risky than short term investments, so again pay

a higher interest rate.


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Bonds

Ï A bond is financial security that is essentially a loan.

Ï A firm sells a bond for its face value, say $1000, promising to repay thisprincipal at the end of some term, say 30 years.

Ï The bond will also include a series of coupon payments, intermediatepayments that will be made to the bond-holder; say, $40 every year.

Ï The interest rate, or cost of borrowing, can be expressed as the ratio of thecoupon payment to the principal; in this case,

$40

$1000= 0.04 or 4%.

Ï The higher the default risk, the higher the coupon payment (hence the interestrate) the firm will have to offer.


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A U.S. Treasury Bond


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Stocks

Ï Unlike bonds, stocks are financial securities that represent partial ownership ofthe firm.

Ï A corporation that sells a stock acts similarly to a partnership taking on a newpartner; though the new shareholder typically owns a tiny fraction of the firm.

Ï When the corporation makes profits, these are either reinvested in the firm –causing a capital gain, or increase in value of the stock – or paid out to the firm’sshareholders as dividends.

Ï By law, corporations must repay bondholders before shareholders. This helpsto ensure that bonds are substantially less risky financial securities to hold thanstocks.


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A Stock Certificate: The Walt Disney Company


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Stock and Bond Markets Provide Capital and Information

Ï After firms sell their stocks and/or bonds, these financial securities can betraded in stock and bond markets.

Ï The existence of these resale markets is beneficial for society, since withoutthem, individuals could not invest in firms without tying up their money for along time.

Ï The price at which a stock trades indicates the degree of confidence in thefirm’s ability to make future profits, since these profits are what is used togenerate a return for investors.

Ï The price at which a bond trades is determined by its coupon payment, relativeto other coupon payments available. But it also reflects the confidence ofinvestors in the firm’s ability to make those payments.


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Why Do Stock Prices Fluctuate So Much?

Ï Since a stock represents a claim to a share of future profits of a firm, changes inexpectations about those profits get reflected in the stock’s price.

Ï When the overall economy performs well, a “rising tide lifts all boats”, and theprice of a stock rises, reflecting investor confidence. The opposite happens in arecession, of course.


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Why Do Stock Prices Fluctuate So Much? cont.

Ï The values shown are stock market index numbers, created as weightedaverages of the underlying stock prices.

Ï By convention, the index is set to a value of 100 in some base year; but since theyear and initial value are arbitrary, it is changes in the index number that arerelevant for determining market performance.


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Which Firm(s) Should You Invest In?

Ï Investment decisions are relatively complicated, but can be made moreintelligently with information from a firm’s financial statements.

Ï In the U.S., publicly owned firms are required to release regular financialstatements prepared using standard accounting methods known as generallyaccepted accounting principles.

Ï Ideally, such statements would present information in an unbiased manner,reducing information costs for investors.

Ï Firms specializing in information sell their services in verifying andinvestigating these reports.


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What’s in a Firm’s Financial Statements?

Ï The two principal items in a firm’s financial statements are:

DefinitionIncome Statement: A summary of the firm’s revenues, costs, and profit over a periodof time – typically a 12-month fiscal year, which does not necessarily coincide withthe calendar year.Balance Sheet: A financial statement that sums up a firm’s financial position on aparticular day, usually the end of a quarter or year.

Ï This summarizes the liabilities (anything owed by a person or firm) and assetsof the firm.

Ï A firm’s net worth is calculated as the amount of its assets minus the amount ofits liabilities.


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Accounting Profit

Ï A firm’s income statement is a financial statement that shows a firm’s revenues,costs, and profit over a period of time.

Ï Profit on the income statement is referred to as net income, and is calculated asrevenue minus operating expenses and taxes paid.

Ï Economists refer to this as accounting profit, and call the listed expensesexplicit costs, costs that involve actually spending money.

Accounting Profit = Revenue−Explicit Costs


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Economic Profit

Ï Economists differ from accountants when calculating profit, becauseeconomists and accountants have different intents:

Ï Accountants present financial information in order to allow people to makejudgments on investments.

Ï Economists are interested in decision-making; whether investing in the firm iswise, and whether the firm should continue to operate.

Ï So it is important for economists to consider the whole opportunity cost of thefirm’s activities, including both explicit and implicit costs: opportunity costs thatdo not require an outlay of money; for example, a firm owner’s time, or thenext-best use for their invested funds. Economic profit is a firm’s revenues minusall of its implicit and explicit costs.

DefinitionOpportunity cost: the highest valued alternative that must be given up to engage insome activity


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The Importance of Accurate Financial Statements

Ï Accurate and truthful financial statements are critical for investors to makeinvestment decisions. Investments help guide resource allocation within theeconomy.

Ï Firms disclose financial statements in periodic filings to the federalgovernment, and in annual reports to shareholders.

Ï If these financial statements are inaccurate, the whole economy suffers, asresources are allocated to less productive activities.

Ï This reduces economic growth directly, and reduces investor confidence whichfurther erodes growth.


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The Accounting Scandals of the Early 2000s

Ï In the early 2000s, top managers at Enron and WorldCom were shown to havefalsified their firms’ financial statements.

Ï See The Economist “A Guide to Corporate Scandals” 15 July 2002

Ï Some of these managers served jail time, but the damage done to manyinvestors was severe.

Ï The government creates regulations to try to minimize the chance of suchdeception. The accounting scandals prompted the Sarbanes-Oxley Act (2002),requiring that CEOs personally certify financial statements, and requiringdisclosure of conflicts of interest from auditors, the accountants charged withchecking the accuracy of financial statements.


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The Ups and Downs of Investing in Facebook

Ï Facebook’s Initial Public Offering (IPO) priced shares of Facebook at $38 a piece. A month after theIPO, the price had fallen by 40%.

Ï However by September 2013, the stock price was over $47. What explains the swings in Facebook’sstock price?

Ï Stock prices are difficult to predict – they represent beliefs about future profitability. News can have astrong impact on prices.

Ï For Facebook, the drops in price had to do with difficulty selling advertising; and the sharp rise in July2013 came after unexpectedly high ad sales on mobile devices.


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Common Misconceptions to Avoid

Ï Profit in economics tends to refer to economic profit, which takes into accountall opportunity costs. This can be substantially different from accountingprofit, which only considers explicit costs.

Ï When a firm makes shares available, it receives the money from the sale.Subsequent trades of those shares do not result in any profit or loss for the firm,however.


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Saving, Investment,and the FinancialSystem


The Financial System

Ï Firms can finance some of their own expansion through retained earnings,reinvesting profits back into the firm.

Ï But often firms want to obtain more funds for expansion than are available inthis way.

Ï They obtain these funds via the financial system: the system of financialmarkets (Example: stock and bond markets) and financial intermediaries(Example: banks) through which firms acquire funds from households.


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Financial Markets and Financial Intermediaries

Ï Financial markets are markets where financial securities, such as stocks andbonds, are bought and sold.

Ï A financial security is a document (sometimes electronic) stating the termsunder which funds pass from the buyer of the security to the seller.

Ï A stock is a financial security representing partial ownership of a firm.

Ï A bond is a financial security promising to repay a fixed amount of funds. Abond essentially a loan from a household to a firm.

Ï Financial intermediaries are firms, such as banks, mutual funds, pension funds,and insurance companies, that borrow funds from savers and lend them toborrowers.

Ï Some financial intermediaries, like mutual funds, sell shares to savers then usethe funds to buy financial securities.


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Three Key Services of the Financial System

Ï The financial system provides three key services:1. Risk-sharing

Ï By allowing investors to spread their money over many different assets, investors canreduce their risk while maintaining a high expected return on their investment.

2. LiquidityÏ The financial system allows savers to quickly convert their investments into cash.

3. InformationÏ The prices of financial securities represent the beliefs of other investors and financial

intermediaries about the future revenue stream from holding those securities.

Ï This aggregation of information allows funds flow to the right firms.


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The Macroeconomics of Savings and Investment

Ï We will now derive the result that the total value of saving in the economy mustequal the total value of investment.

Ï Recall that we can express the GDP of a nation (Y ) as the sum of consumption(C), investment (I), government purchases (G), and net exports (NX). That is,

Y = C + I +G+NX

Ï For the sake of simplicity, we will assume a closed economy (i.e.,EX = IM = 0 = NX), with no exports or imports; so

Y = C + I +G

Ï We can rearrange this to obtain an expression for investment:

I = Y −C −G

Ï That is, investment in a closed economy is equal to income minusconsumption and government purchases.


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Savings

Ï Now let’s examine savings. Savings is composed of private savings (by households, SPrivate) andpublic savings (by the government, SPublic).

Ï SPrivate is equal to all household income that is not spent; household incomes derive from thepayments for factors of production (Y ) and transfer payments (TR); households spend moneyon consumption (C) and taxes (T). So

SPrivate = Y +TR−C −T

Ï The government “saves” whatever it brings in but does not spend (this may be negative, knownas dissaving):

SPublic = T −G−TR

Ï So total saving is:

S = SPrivate +SPublic

= Y +TR−C −T +T −G−TR

= Y −C −G


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Savings Equals Investment

Ï The two previous slides led us to the same expressions for savings andinvestment. So we conclude that savings must equal investment:

S = I

Ï When SPublic is zero, the government spends as much as it brings in; this isknown as a balanced budget. Negative and positive values for SPublic are knownas budget deficits and budget surpluses respectively.

Ï Since the federal government funds its current deficits with borrowing (sellingTreasury securities; e.g., bonds), this takes away from the money available forinvestment spending.


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Non Sequitur : Ebenezer Scrooge – Accidental Promoter ofEconomic Growth?

Ï In Charles Dickens’ A Christmas Carol, Ebenezer Scrooge initially spends little.In the book, this is portrayed negatively, but is this really fair?

Ï By declining to consume, Scrooge elects to save. Society’s resources can then beset toward investment, increasing productive capacity and hence futureconsumption.

Ï By the end of the story, Scrooge starts to spend his wealth. While thisencourages current production, society was probably better served – andachieved stronger growth – when Scrooge chose to save instead.

Ï Slate “What I Like About Scrooge” by Steven E. Landsburg, 9 December 2004


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The Market for Loanable Funds

Ï If savings must equal investments, how exactly does this occur?Ï The financial system is composed of many different markets – the market for

stocks, for bonds, for certificates of deposits at banks, etc.Ï A convenient way to model these is as a single market: the market for loanable

funds, which is a (conceptual) interaction of borrowers and lenders determiningthe market interest rate and the quantity of loanable funds exchanged.

Ï For now, we will assume that interactions are only between domestichouseholds and firms – there is no interaction from foreign lenders andborrowers.


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Ï Firms borrow loanable funds from households. They borrow more whenhouseholds demand a lower return on their money – a lower real interest rate.

Ï Households supply loanable funds to firms. They provide more when firmsoffer them a greater reward for delaying consumption – a higher real interestrate.

Ï Governments, through their saving or dissaving, affect the quantity of fundsthat “pass through” to firms.


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I ,S

r

Sd

Id

I0 = S0

r0

Demand for loanable funds

Supply for loanable funds

Loanable funds


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An Increase in the Demand for Loanable Funds

Ï Suppose that technological change occurs (permanently), so that investmentsbecome more profitable for firms.

Ï This will increase the demand for loanable funds.Ï The real interest rate will rise, as will the quantity of funds loaned.

I ,S

r

Sd

Id

I0 = S0

r0


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Crowding Out in the Market for Loanable Funds

Ï Suppose the government runs a budget deficit; i.e., G > T .

Ï To fund the deficit, it sells bonds to households, decreasing the supply of fundsavailable to firms.

Ï This raises the equilibrium real interest rate, and decreases the funds loaned tofirms.

Ï This is referred to as crowding out: the decline in private expenditures as aresult of increases in government purchases.


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Crowding Out in the Market for Loanable Funds

I ,S

r

Sd0 = Y −Cd −G0

Id

Sd1 = Y −Cd −G1

I0 = S0I1 = S1

r0

r1


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How Important Is Crowding Out?

Ï In practice, the effect of government budget deficits and surpluses on theequilibrium interest rate is relatively small.

Ï How small? According to one study, increasing borrowing by 1% of GDP wouldincrease the real interest rate 0.003 points.

Ï Why would the effect be so small?Ï Interest rates are influenced by global markets, so even a few hundred billion

dollars is a relatively minor amount.


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Aggregate Expenditure

Marginal Propensity toConsume and Save,and the Multiplier

Consumption & SavingBehavior: Extensions

The AggregateDemand Curve

Components of Real Aggregate Expenditure (Spending)

Ï The table below shows the values of the components of expenditure in 2012,with prices in 2009 dollars.

Ï Clearly consumption is the largest portion, with planned investment andgovernment expenditures being roughly similarly sized.

Ï Net exports were negative in 2012: the value of U.S. imports was greater thanthe value of U.S. exports.

Ï For the next several slides, we will examine each component in more detail.


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Consumption

Ï Consumption tends to follow a relatively smooth, upward trend; its growth declinesduring periods of recession. What affects the level of consumption?

Ï Current disposable incomeÏ Household wealthÏ Expected future incomeÏ The price levelÏ The interest rate

Ï We will proceed by examining how each of these affects the level of consumption.


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Determinants of Consumption

Ï Current disposable incomeÏ Consumer expenditure is largely determined by how much money consumers

receive in a given year. We measure this by personal income, minus personalincome taxes, plus government transfer payments such as Social Security.

Ï Income expands most years; hence so does consumption.

Ï Household wealthÏ A household’s wealth can be thought of as its assets (like homes, stocks and

bonds, and bank accounts) minus its liabilities (mortgages, student loans, etc.).Ï Households with greater wealth will spend more on consumption, even with

similar incomes. Recent studies estimate that an extra $1,000 in wealth will resultin $40–$50 in extra annual consumption spending, holding constant the effect ofincome.


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More Determinants of Consumption

Ï Expected future incomeÏ Most people prefer to keep their consumption fairly stable from year to year, a

process known as consumption-smoothing.Ï Example: Sales people working on commission might have high incomes in some

years, and low incomes in others. In order to predict their consumption, wewould need to know what they believed their income would be in the future.

Ï The price levelÏ As prices rise, household wealth falls. If you have $100,000 in the bank, that will

buy fewer products at higher prices. Consequently, higher prices result in lowerconsumption spending.

Ï The interest rateÏ Higher real interest rates encourage saving rather than spending; so they result in

lower spending, especially on durable goods.


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The Consumption Function

Ï How strong is the relationship between income and consumption?Ï As the graphs demonstrate, the answer is “very strong”. A straight line (called

the consumption function) describes this relationship very well, suggestingthat households spend a consistent fraction of each extra dollar of realdisposable income on consumption.


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Intel Moves into Tablets

Ï Intel’s dependence on microprocessor sales led to it having sharp declines insales during recessions. Computers are durable goods, after all, and sales ofdurables are very strongly affected by recessions.

Ï In an effort to smooth out its sales, Intel has recently started to produceprocessors for tablets and smart phones; these are less durable than regularcomputers, so are less affected by recessions.


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Planned Investment

Ï Investment has increased over time, but unlike consumption, it has not increasedsmoothly, and recessions decrease investment more

Ï What affects the level of investment?Ï Expectations of future profitabilityÏ Interest rateÏ TaxesÏ Cash flow


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Determinants of Planned Investment

Ï Expectations of future profitabilityÏ Investment goods, such as factories, office buildings, machinery, and equipment,

are long-lived. Firms build more of them when they are optimistic about futureprofitability. Recessions reduce confidence in future profitability, hence duringrecessions, firms reduce planned investment.

Ï Purchases of new housing are included in planned investment. In recessions,households have reduced wealth, and less incentive to invest in new housing.

Ï Interest rateÏ Since business investment is sometimes financed by borrowing, the real interest

rate is an important consideration for investing.Ï A higher real interest rate results in less investment spending, and a lower real

interest rate results in more investment spending.


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Determinants of Planned Investment – continued

Ï TaxesÏ Higher corporate income taxes on profits decrease the money available for

reinvestment and decrease incentives to invest by diminishing the expectedprofitability of investment.

Ï Similarly, investment tax incentives tend to increase investment.

Ï Cash flowÏ Firms often pay for investments out of their own cash flow, the difference

between the cash revenues received by a firm and the cash spending by the firm.Ï The largest contributor to cash flow is profit. During recessions, profits fall for

most firms, decreasing their ability to finance investment.


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Planned Investment, Actual Investment, and Inventories

Ï Planned investment spending does not include the build-up of inventories:goods that have been produced but not yet sold:

Planned investment = Actual investment−unplanned change in inventories

Ï Inventories play a critical role in this model of the economy.

Ï When planned aggregate expenditure is less than real GDP, firms willexperience unplanned increases in inventories.


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The Important Role of Inventories

Ï If spending returns to normal levels following a downturn, firms have excessinventories to sell; and they will do this instead of increasing production tonormal levels.

Ï Example: In 2009, the “Great Recession” was about to end. But real GDP fellsharply in the first quarter of 2009 – at a 6.7% annualized rate.

Ï Economists estimate that almost half of this decline was due to firms cuttingproduction as they sold off their unintended accumulation of inventories.

Ï Investment is highly procyclical (procyclical means – when Y increases Iincreases and vice versa).

Ï Inventories are the most volatile (and procyclical) component of GDP.


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The Effect of Unplanned Changes in Inventories

Ï Can inventories be a signal of future economic activity?Ï Yes, can predict recessions (a rapid rise in inventories – unplanned inventories)Ï Yes, can predict expansions (a smooth rise in inventories – planned inventories).

Ï Example:Ï Firms like Apple don’t want to keep too much inventory on hand. Not only is it

expensive, but technology quickly becomes outdated.Ï Apple forecasts its sales each month, and plans to have adequate inventory to

cover sales. If sales are stronger than expected, it initially covers the extra salesthrough falling inventories.

Ï The falling inventories signal to Apple that it should hire more workers in order toincrease production.


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Consumption vs. Investment (Percent Change – Annual)


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Animal Spirits & Irrational Exuberance

Ï Fluctuations with contagious swings of optimism and pessimism, called“animal spirits” by John Maynard Keynes [see next slide] and “irrationalexuberance” by former Fed chairman Alan Greenspan.


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John Maynard Keynes (canes)

Ï In 1936 Keynes published TheGeneral Theory of Employment,Interest, and Money establishingKeynesian economics as a majoralternative to the Classical model.

Ï Keynes questioned the classicalview that economies movedquickly to their long-runequilibriums.

Ï Stating that “in the long-run, weare all dead”, Keynes argued thatthe primary focus ofmacroeconomists should be theshort-run.


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Government Purchases

Ï Real government purchases include purchases at all levels of government:federal, state, and local.

Ï This category does not include transfer payments; only purchases for which thegovernment receives some good or service.

Ï Government purchases have generally, though not consistently, increased overtime; exceptions include the early 1990s (end of cold war) and due to state andlocal cutbacks after 2009.


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Net Exports

Ï Net exports equals exports minus imports.Ï The value of net exports is affected by:

Ï Price level in U.S. vs. the price level in other countriesÏ U.S. growth rate vs. growth rate in other countriesÏ U.S. dollar exchange rate

Ï U.S. net exports have been negative for the last few decades. The value typicallybecomes higher (less negative) during a recession, as spending on imports falls.


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Autonomous and Induced Expenditures

Ï In our model, autonomous consumption, (planned) investment, andgovernment purchases, are autonomous expenditures: their level does NOTdepend on the level of GDP.

Ï Consumption has both an autonomous and induced effect. [See next slide.]

Ï Increases in autonomous expenditure lead to real GDP increasing by more thanthe change in autonomous expenditures; this is the multiplier effect.

Ï The value of the increase in equilibrium real GDP divided by the increase inautonomous expenditures is the multiplier.


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Consumption: Autonomous and Induced

Ï Autonomous consumption is consumption expenditures by the householdsector that are unrelated to and unaffected by the level of income orproduction.

Ï This is one of two basic classifications of consumption.

Ï The other is induced consumption, consumption expenditures that are basedon the level income or production.

Ï In other words, household consumption can be divided into:1. a minimum or baseline amount of expenditures which, in theory, would be

undertaken even if the household sector had no income and2. additional expenditures that result from the income available to the household

sector.

Ï The bulk of consumption expenditures fall in the induced category becausepeople are prone to base their spending on available income.


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The Multiplier Effect in Action

Ï Initially, real GDP rises by the amount of the increase in autonomous expenditure. Thiscauses an increase in real GDP, which causes an increase in production, which causesan increase in real GDP . . .


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Eventual Effect of the Multiplier

Ï We cannot say how long this adjustment to macroeconomic equilibrium willtake – how many “rounds”, back and forth.

Ï But we can calculate the value of the multiplier, as the eventual change in realGDP divided by the change in autonomous expenditures (planned investment,in this case):

∆Y

∆I= Change in real GDP

Change in investment spending= $400 billion

$100 billion= 4

Ï With a multiplier of 4, each $1 increase in planned investment (or any otherautonomous expenditure) eventually increases equilibrium real GDP by $4.


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Marginal Propensity to Consume (MPC)

Ï The marginal propensity to consume (MPC) is the slope of the consumptionfunction, the relationship between consumption spending and income.


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Marginal Propensity to Consume (MPC) – continued

Ï We can therefore estimate the MPC by estimating the slope of the consumptionfunction:

MPC = Change in consumption

Change in income= ∆C

∆Y

Ï The previous table shows the relationship between consumption and nationalincome for an imaginary economy, keeping net taxes constant.

Ï As national income rises by $2,000 billion consumption rises by $1,500 billion.

Ï So the marginal propensity to consume for this economy is:

MPC = ∆C

∆Y= $1,500

$2,000= 0.75


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The Multiplier and the Marginal Propensity to Consume

Ï How can we know the eventual value of the multiplier?Ï In each “round”, the additional income prompts households to consume some

fraction (the marginal propensity to consume).Ï The total change in equilibrium real GDP equals:

The initial increase in planned investment spending = $100 billion

Plus the first induced increase in consumption = MPC ×$100 billion

Plus the second induced increase in consumption = MPC × (MPC ×$100 billion)

= MPC2 ×$100 billion

Plus the third induced increase in consumption = MPC × (MPC2 ×$100 billion)

= MPC3 ×$100 billion

and so on . . .Dennis C. Plott (UIC) The Demand Side: Consumption, Saving, and Investment ECON 121 – Summer 2015 79 / 101

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A Formula for the Multiplier

Ï This becomes the infinite sum:

Total change in GDP = $100 billion+MPC ×$100 billion+MPC2 ×$100 billion+MPC3 ×$100 billion+ . . .

Ï Which we can rewrite as:

Total change in GDP = $100 billion× (1+MPC +MPC2 +MPC3 + . . .)

by factoring out the initial $100 billion increase in investment. Since MPC is less than 1, the expression inparentheses is:

1

1−MPC

Ï In our case, MPC = 0.75; so the multiplier is 1/(1–0.75) = 4. A $100 billion increase in investmenteventually results in a $400 billion increase in equilibrium real GDP.

Ï The general formula for the multiplier is:

Multiplier = Change in equilibrium real GDP

Change in autonomous expenditure= 1

1−MPC


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Geometric Series

Ï A geometric series is a series with a constant ratio between successive terms.

ar0 +ar1 +ar2 +ar3 + . . .

if a = 1

2and r = 1

2then

1

2+ 1

4+ 1

8+ 1

16+ 1

32+ . . . = 1

21 + 1

22 + 1

23 + 1

24 + 1

25 + . . . =∞∑

n=1

1

2n

Ï If r is between −1 and +1, the terms of the series become smaller and smaller, approaching zero in thelimit and the series converges to a sum. In the case above, where r is one half, the series has the sumone.

Ï In the special case that |r| < 1, the infinite sum exists and has the following value:

a

1− r


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Income, Consumption, and Saving

Ï By definition, income not spent is saved. Therefore we can write:

National income = Consumption+Saving

Y = C +S

Ï Any change in national income can be decomposed into changes in the itemson the right hand side:

∆Y =∆C +∆S

Ï Now divide through by ∆Y :

∆Y

∆Y= ∆C

∆Y+ ∆S

∆Y


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Marginal Propensity to Save

∆Y

∆Y= ∆C

∆Y+ ∆S

∆Y

Ï ∆S

∆Yis the amount by which savings changes, when (disposable) income

changes. This is known as the marginal propensity to save. We can rewrite theequation above as:

1 = MPC +MPS

Ï That is, the marginal propensity to consume plus the marginal propensity tosave must equal 1. This is because part of any increase in income is consumed,and the rest is saved.


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The Multiplier in Reverse: the Great Depression

Ï The multiplier can work in reverse too, like it did during the Great Depressionof the 1930s.

Ï Several events, including the stock market crash of October 1929, led toreductions in investments by firms.

Ï Real GDP fell, so consumers cut back on spending, prompting firms to reduceproduction more, so consumers spent even less . . .

Ï Aggregate expenditures fell initially, due to the decrease in investment.

Ï This prompted a multiplied effect on equilibrium real GDP.

Ï Recovery from the Great Depression took many years; unemploymentremained above 10% until the U.S. entered World War II in 1941.


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Summarizing the Multiplier Effect

Ï The multiplier effect occurs both for an increase and a decrease in plannedaggregate expenditure.

Ï Because the multiplier is greater than 1, the economy is sensitive to changes inautonomous expenditure.

Ï The larger the MPC, the larger the value of the multiplier.Ï Our model is somewhat simplified, omitting some real-world complications.

For example, as real GDP changes, imports, inflation, interest rates, and incometaxes will change.

Ï The last point generally means that the value we estimate for the multiplier, fromthe MPC, is too high. We will address some of these shortcomings.


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The Paradox of Thrift

Ï Recall the savings identity: savings equals investment.Ï This implied that savings were the key to long-term growth.

Ï But consider what happens in the short-term if people save more:consumption decreases, and incomes decrease, so consumption decreasesmore . . . potentially pushing the economy into recession.

Ï John Maynard Keynes referred to this as the paradox of thrift: what appears to befavorable in the long-run may be counterproductive in the short-run.

Ï Economists debate whether this paradox of thrift really exists; increasingsavings decreases the real interest rate; the consequent increase in investmentspending may offset the decrease in consumption spending.

Ï This is a real-world data-driven debate, unable to be settled by our simple model.


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Behavioral Biases in Saving Behavior

Ï Economists have generally assumed that people make their saving decisionsrationally, just as they make other decisions about choices in consumption andthe labor market.

Ï Saving decisions involve thinking about trade-offs between present and futureconsumption.

Ï Recent work in behavioral economics has highlighted the role of psychologicalbiases in saving behavior and has demonstrated that seemingly small changesin the way saving programs are designed can result in big behavioral changes.

Ï For example, in studying retirement systems, researchers have found thatsimply changing the enrollment process from an opt-in structure to an opt-outsystem in which people are automatically enrolled unless they check the “no”box dramatically increases enrollment in retirement pension plans. Behavioraleconomists argue that people find this option attractive because it is easier forthem to commit to making sacrifices tomorrow than it is for them to makethose sacrifices today.


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Laibson’s Pull of Instant Gratification

Ï Keynes called the consumption function a “fundamental psychological law”. Yet, as wehave seen, psychology has played little role in the subsequent study of consumption.Most economists assume that consumers are rational maximizers of utility who arealways evaluating their opportunities and plans in order to obtain the highest lifetimesatisfaction.

Ï More recently, economists have started to return to psychology. They have suggestedthat consumption decisions are not made by the ultra-rational Homo economicus butby real human beings whose behavior can be far from rational. This new sub-fieldinfusing psychology into economics is called behavioral economics. The mostprominent behavioral economist studying consumption is Harvard professor DavidLaibson.

Ï Laibson notes that many consumers judge themselves to be imperfect decisionmakers. In one survey of the American public, 76 percent said they were not savingenough for retirement. In another survey of the baby-boom generation, respondentswere asked the percentage of income that they save and the percentage that theythought they should save. The saving shortfall averaged 11 percentage points.


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Two Questions and Time Inconsistency

1. Would you prefer (A) a candy today, or (B) two candies tomorrow?

2. Would you prefer (A) a candy in 100 days, or (B) two candies in 101 days?

Ï In studies, most people answered (A) to 1 and (B) to 2.

Ï A person confronted with question 2 may choose (B).

Ï But in 100 days, when confronted with question 1, the pull of instantgratification may induce her to change her answer to (A).


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The Price Level and Aggregate Expenditure

Ï As demand for a product rises, we expect that two things will occur: productionwill increase, and so will the product’s price.

Ï Our model has concentrated on the first of these, but what about price changes?

Ï In the larger economy, we also expect that an increase in aggregate expenditurewould increase the price level.

Ï Will this price level change have a feedback-effect on aggregate expenditure?Ï We generally expect that it will: increases in the price level will cause aggregate

expenditure to fall, and decreases in the price level will cause aggregateexpenditures to rise.


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How Does the Price Level Affect Aggregate Expenditure?

Ï The price level affects aggregate expenditure in three ways:1. Rising price levels decrease the real value of household wealth, causing

consumption to fall.2. If price levels rise in the U.S. faster than in other countries, U.S. exports fall and

imports rise, causing net exports to fall.3. When prices rise, firms and households need more money to finance buying and

selling. If the supply of money doesn’t change, the interest rate must rise; this willcause investment spending to fall.

Ï Of course, these effects work in reverse if the price level falls.

Ï Each effect works in the same direction; so rising price levels decreaseaggregate expenditure, while falling price levels increase aggregate expenditure.


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The Aggregate Demand Curve

Ï Consequently, there is an inverse relationship between the price level and real GDP.

Ï This relationship is known as the aggregate demand curve.

DefinitionAggregate demand (AD) curve: A curve that shows the relationship between the price leveland the level of planned aggregate expenditure in the economy, holding constant all otherfactors that affect aggregate expenditure.


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Aggregate Demand and Aggregate Supply Model

Ï Our goal is to model the economy in the short-run. By doing so, we will be ableto understand why real GDP, the level of employment, and the price levelfluctuate.

Ï Our tool for doing this will be the aggregate demand and aggregate supply model;to build it up, we must determine how aggregate demand and aggregate supplyare each formed.

DefinitionAggregate demand and aggregate supply model: A model that explains short-runfluctuations in real GDP and the price level.


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A Sneak Peek at the Model

Ï In the short run, real GDP and the price level are determined by the intersection of the aggregatedemand (AD) curve and the short-run aggregate supply (AS) curve.

DefinitionAggregate demand (AD) curve: A curve that shows the relationship between the price level and thequantity of real GDP demanded by households, firms, and the government.Short-run aggregate supply (AS) curve: A curve that shows the relationship in the short run between theprice level and the quantity of real GDP supplied by firms.


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The Four Components of Real GDP

Ï Real GDP has four components: consumption (C), investment (I), governmentpurchases (G), and net exports (NX):

Y = C + I +G+NX

Ï Government purchases are generally determined by the decisions ofpolicymakers; but each of the others changes, depending on the price level. Wewill examine each in turn.

Ï The wealth effect: how a change in the price level affects consumption (C)Ï Household consumption is most strongly determine by income, but it is also

affected by wealth.Ï Some household wealth is held in nominal assets; so as price levels rise, the real

value of household wealth declines. This results in less consumption.


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Why is the AD Curve Downward Sloping?

Ï The interest-rate effect: how a change in the price level affects investment (I)Ï When prices rise, households and firms need more money to finance buying and

selling.Ï This increase in demand for money causes the “price” of holding money (the

interest rate) to rise, discouraging firm investment.

Ï The international-trade effect: how a change in the price level affects netexports (NX)

Ï When U.S. price levels rise, U.S. exports become more expensive and importsbecome relatively cheaper. Fewer exports and more imports means net exportsfalls.

Ï Each effect moves in the same direction: an increase in the price level decreasesreal GDP.


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Shifts of the AD Curve vs. Movements along It

Ï The aggregate demand curve shows the relationship between the price leveland real GDP demanded, holding everything else constant.

Ï A change in the price level not caused by a component of real GDP changingresults in a movement along the AD curve.

Ï A change in some component of aggregate demand, on the other hand, willshift the AD curve.


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Shifts of the AD Curve vs. Movements along It


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Recessions and the Components of AD – part 1

Ï We can understand the 2007–2009 recession better by examining whathappened to the components of real GDP.

Ï (The red bar indicates the period of the recession, per the NBER).Ï Consumption spending fell, relative to potential GDP during the recession.

Ï This was unusual: consumption usually stays steady during a recession.Ï Consumption also stayed low in the four post-recession years.


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Ï Residential investment had been falling before the recession, and continued tofall during it.

Ï Spending on residential investment has continued to be below thepre-recession boom levels.


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Ï Net exports increased (became less negative) just before and during therecession.

Ï This was in part due to the falling value of the $US.Ï After the recession, net exports started to decrease once more, but then have

stayed relatively steady.Ï Loose monetary policy has kept the value of the $US down.


economics 121 principles of macroeconomics the demand side ... · aggregate demand (ad) the effect...

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